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IMF Report on Iran's Economy

March 1, 2017

On February 27, the International Monetary Fund (IMF) released its annual report on Iran’s economy. The organization “commended the authorities for achieving an impressive recovery in economic growth after the lifting of nuclear sanctions in 2016, maintaining inflation in single digits, and stabilizing the foreign exchange market.” But it also warned that the banking systems’ weaknesses and structural bottlenecks were holding the economy back. Foreign banks also hesitated to re-establish financial links in 2016. The following are excerpts from the report.

CONTEXT

1. Higher oil production and exports, following the removal of nuclear sanctions in January 2016, is supporting a strong rebound in growth. The prudent monetary and fiscal policies implemented in recent years paved the way for inflation to fall to single digits and stabilized the foreign exchange market. Progress was made in addressing Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) deficiencies, including passage of a CFT law. Foreign investors are planning sizeable investments in the hydrocarbon and manufacturing sectors.

2. Still Iran faces considerable challenges in realizing its full potential. The fall in oil prices since their 2014 peak further reduced fiscal space and buffers already eroded under sanctions. Limited access to correspondent banking relations (CBR) has constrained trade, investment inflows and access to international reserves (Box 1). More recently, renewed uncertainty regarding sanctions is dampening sentiment. Domestically, the banking system is fragile and unable to support the recovery. Unemployment remains high and private sector job creation is slow. With per capita incomes unchanged from a decade ago and poverty on the rise, pressure to realize rapid gains is high. Presidential elections are scheduled for May 2017.

3. The authorities are putting in place the elements of an ambitious reform plan to address these challenges, consistent with past IMF advice. They remain committed to prudent monetary and fiscal policies to underpin hard won economic stability. Under their Financial Sector Reform Plan, draft Central Bank and Banking bills aim to modernize the monetary policy framework and strengthen supervisory powers. The government has begun to clear its payment arrears, provided seed funds to recapitalize some banks, and plans to expand tax collections. The Sixth National Development Plan (NDP) aims to develop the private sector and reduce oil dependency. The challenge will be to prioritize and coordinate these complex reforms to definitively address structural weaknesses, sustain economic and financial stability, and secure higher, more inclusive growth.

Impediments to Correspondent Banking with Iran

Despite the lifting of nuclear sanctions by the JCPOA—a multilateral agreement reached between Iran and the P5+1 which was ratified by the UN—on January 16, 2016, non-U.S. global banks are reluctant to re-engage Iranian banks because of remaining sanctions as well as AML/CFT concerns, including opacity of ownership of legal entities, and health of local banks.

ECONOMIC DEVELOPMENTS, OUTLOOK, AND RISKS

A. Recent Developments

4. Economic growth rebounded in 2016/17 on the back of higher oil production but nonoil activity remained weak (Table 1, Figure 1). Boosted by the swift recovery in oil production and exports, real GDP grew by 7.4 percent in the first half 2016/17, recovering from recession in 2015/16. However, non-oil sector growth averaged just 0.9 percent reflecting continued difficulties in access to finance and depressed consumption. Unemployment had risen to 12.7 percent by the end-Q2 (Table 2).

5. Inflation declined to low and single digits (Figure 2). Inflation fell to a multi-year low of 6.8 percent y/y in June 2016, down from a peak of 45 percent in June 2013 reflecting favorable food prices and prudent policies. Inflation has since hovered in the 9½ percent range on higher world food prices and faster liquidity growth. M2 had risen by 28.3 percent y/y by end-December 2016 driven by CBI support to banks and the government drawing on its revolving facility.

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9. The financial sector remains weak. NPLs (non-performing loans) are high (about 12 percent), but would be significantly higher were it not for recent regulations permitting the rollover of overdue loans into new loans contingent on a partial repayment. The implementation of International Financial Reporting Standards (IFRS) in banks in 2016 shows that the capital adequacy ratio (CAR) of the banking system has declined from 8.4 percent in March 2012 to 5.8 percent in March 2015. It also revealed substantial capital needs in state-owned banks (16 percent of total assets) where the average CAR is negative. Profitability remains constrained by the high cost of funds—some banks are competing aggressively for deposits by offering rates above the mandated caps and the interbank market rate remains at around 19 percent—and the lending rate cap.

B. Outlooks and Risks

11. Growth is projected to stabilize at 4½ percent over the medium-term as the recovery broadens. Real GDP growth is projected to reach 6.6 percent in 2016/17 reflecting the rebound in oil production and exports (up 25 and 75 percent, respectively), and to ease to 3½ percent in 2017/18 as oil production remains at the OPEC target. Thereafter, higher FDI and a gradual improvement in domestic credit conditions as financial reforms proceed drives investment, which combined with improved economic efficiency from updated production capacity, lifts non-oil sector growth. The current account is forecast to remain in surplus as higher exports offset the pick-up in imports related to investment and pent-up domestic demand. Inflation is expected to temporarily rise to 11.9 percent by end-2017/18 reflecting recent liquidity growth and pass-through from exchange rate depreciation, but returns to single digits with prudent fiscal and monetary policies. The pace of job creation lags that needed to absorb the large number of new entrants and unemployment remains high.

12. Risks are to the downside (see Risk Assessment Matrix). The renewed uncertainty surrounding the JCPOA, and especially relations with the U.S., could deter investment and trade with Iran and short-circuit the anticipated recovery. If the agreement is derailed, the economy could risk recession. Likewise, any challenges in implementing the FATF action plan could hamper CBRs, especially if counter-measures were re-imposed. Lower oil prices could increase pressure on export and budget revenues, reducing fiscal space. Domestically, failure to garner support for the ambitious reform program, especially banking sector reform, would see inflation rise, banking stress intensify, and growth slow. The complex, intertwined, reform agenda also demands careful coordination and sequencing.

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Policy Discussions

A. Strengthening the Financial System to Support Growth

14. The banking system is fragile. A legacy of government payment arrears, directed and connected lending, and poor risk management practices have left banks’ balance sheets badly impaired and capital positions weak (Figure 4). The authorities’ provisional estimates suggest that a large share of bank assets are frozen in NPLs or non-earning real estate or public enterprise assets. The fact that NPLs can only be written-off after 10 years and when they are 100 percent provisioned encourages banks to rollover loans and helps explain the rapid pace of headline credit growth despite high real interest rates and problems in access to finance (Section D).